The Return of Moderation: Sea of Tranquility

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A decade ago, the business cycle was an endangered species. Recessions in the rich world had become rare, shallow and short; inflation was predictably low and boring. Economists dubbed this the “Great Moderation” and gave credit for it to deft macroeconomic management by central banks. Such talk, naturally, ended abruptly with the financial crisis.

But obituaries of the Great Moderation may have been premature. Since America emerged from recession in 2009, its growth, although low, has been as stable as during the Great Moderation’s heyday, from the early 1980s to 2007, judging by the volatility of quarterly gross domestic product (see chart below) and monthly job creation. That, in turn, has pushed the gyrations of stock and bond prices to their lowest levels since 2007. The trend is less pronounced outside America, but economists at Goldman Sachs nonetheless find that pre-crisis levels of tranquility have returned in Germany, Japan and Britain.

It is the absolute level of growth that has been disappointing. In America it has averaged a little over 2 percent for the past four years, and fell almost to zero in the first quarter of this year. This looks like a temporary setback due to bad weather, but the Federal Reserve’s hopes for an acceleration to nearly 3 percent seem likely to be dashed once again. The euro zone, meanwhile, grew by just 0.8 percent in the first quarter (on an annualized basis), half the pace economists had predicted, but perfectly in line with the average of the previous nine months.

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Strategists at Société Générale, a bank, note that since 1969 the S&P 500 has dropped by 1 percent or more 27 days a year on average; in the past 12 months, there have been only 19 such days. This docility has increased investors’ appetite for both stocks and bonds, which helps explain why the stock market hovers near record highs and yields on Treasuries near historic lows.

Many of the causes suggested for the original moderation do not apply to its revival. Just-in-time inventory management had enabled firms to adjust stocks more judiciously. Instead of rising and falling together, inventories and sales moved in opposite directions, tamping down a once significant source of swings in output. But Jason Furman, Barack Obama’s chief economist, notes that since 2008 inventories and sales have been moving in tandem again. Another theory was that easier access to credit, such as through “cash-out” refinancing of mortgages, had made it easier for consumers to keep spending even when their incomes dipped. But since 2008, though credit-card debt and cash-out refinancing have plummeted, consumption has remained stable.

A final theory invoked good luck: the world had endured fewer shocks since the early 1980s. But Furman points to several shocks since 2008, including the jump in oil prices when Libya’s exports were disrupted in 2011.

That leaves monetary policy. In a paper published in 2001, Olivier Blanchard and John Simon noted that both the level and volatility of inflation fell sharply in the 1980s. Stable inflation meant the Fed was less likely to tighten in the face of supply shocks such as higher oil prices and quicker to ease when recession threatened.

This seems to explain why, despite the Fed’s failure to prevent the Great Recession, the Great Moderation endures. Although the prices of energy and food have bounced up and down since 2008, inflation expectations and, until recently, core inflation have fluctuated around 2 percent, giving the Fed no reason to raise interest rates. Of course, with short-term interest rates stuck at zero, the Fed has also found it harder to stimulate the economy to combat high unemployment. But it has developed substitutes: “quantitative easing” (the purchase of bonds with newly created money) and “forward guidance” (promises to keep rates at zero for a long time) have held down long-term rates. This has provided some spur to spending and taken much of the guesswork out of predicting interest rates, which explains why bond yields are both so low and so stable. Similarly, the European Central Bank’s promise in 2012 to do whatever it takes to save the euro has brought peripheral European bond yields down dramatically.

This also points to a dark side to the moderation. Hyman Minsky, an economist who died in 1996, argued that long periods of stability are ultimately destabilizing. When assets are less volatile, buying them with borrowed money seems safer. Financial innovation exploits the demand for leverage with products like subprime mortgages. This briefly enhances stability, by enabling consumers to keep spending even when their incomes take a hit. But the build-up of debt raises the risk of a far more violent crisis and recession — especially if, as now, there is little room for central banks to cut interest rates. Thus the deviation of annual growth from its long-run average is close to historic lows, Furman notes, but the deviation of the growth of the past decade, which takes in the financial crisis, is near historic highs.

The big question is whether the return of the Great Moderation has also prompted a return of the sort of risk-taking that produced the crisis. There are troubling signs. Issuance of poorly-rated “junk” bonds has risen sharply, as have loans to already highly indebted firms; former pariahs like Greece can now borrow at single-digit rates. Charlie Himmelberg, an author of Goldman’s report, considers the appetite for leveraged assets rational, since the Great Moderation makes borrowing safer. Any threat of a systemic crisis is far off, he says, because new regulations have made it much harder for banks and investors to lever themselves. But even he concedes, “Eventually, this will lead to no good. If leverage wants to come back to the system, it just does.”